RBI interventions to play crucial role in India’s economic recovery

Unbridled foreign currency inflows into Indian stock markets can lead to an appreciation of, and volatility in, the Indian currency. Thus, the central bank’s role in ensuring that the rupee trades in a narrow band will be very important in the coming quarters.

The latest prognosis on the Indian economy is even better than it was just a week ago. “Based on the faster pace of economic normalisation, we recently raised our Q4 2020 (Q3FY21) and Q1 2021 (Q4FY21) GDP growth forecasts to 1.5 per cent y-o-y and 2.1 per cent, respectively, from -0.8 per cent and -1.2 per cent previously,” Japanese I-bank and global brokerage firm Nomura has said.

Economy to contract less than expected

These latest projections mean the bank is now projecting a much better than expected -6.7 per cent contraction for the current financial year compared to a shrinkage of more than 8 per cent forecast earlier (the government has forecast a contraction of -7.7 per cent for 2020-21). It now expects the Indian economy to grow 13.5 per cent next year against the consensus growth rate of 10 per cent.

The Japanese firm added that the Indian economy is expected to enter a “Goldilocks” period in 2021 – characterised by moderate inflation and steady growth.

Rupee value could upset calculations

The one wild card in this idyllic projection is the value of the rupee. With billions of dollars flowing into the Indian economy, both as foreign direct investment (FDI), as a result of the Modi government’s reforms initiatives and its aggressive wooing of companies looking for alternatives to China, as well as the massive inflows into Indian stocks, there is a very real fear of the rupee appreciating.

Foreign inflows could increase rupee value

With US President-elect Joe Biden expected to unveil a $1.5-trillion stimulus package to kick-start his country’s stuttering Covid-struck economy and with excess liquidity sloshing around in many of the world’s developed economy, the influx of humungous sums of money into Indian stocks is expected to continue unabated.

This will put pressure on the rupee as foreign investors buy the Indian currency to invest in this country’s growth prospects. That, in turn, will lead to an appreciation in the value of the rupee – unless the Reserve Bank of India (RBI) intervenes actively in the market to stabilise its value.

High-priced Indian currency can stall recovery

An appreciating rupee vis-à-vis the dollar will please only those who want to score brownie points and gain bragging rights. In the real world, it can, more than any other factor, stymie the expected recovery of the Indian economy.

As the Indian economy gets back to the high growth path, both exports and imports will rise. The latter, in fact, is critical for the success of the Modi government’s ambitious production-linked incentive (PLI) schemes for smartphones, textiles, batteries, electronics, solar panels, etc. That’s because companies assembling these products in India will have to import components from other countries, producing the finished product and then exporting the same all over the world.

An appreciating rupee will make Indian exports less competitive, thus, significantly diluting the advantage that the PLI scheme bestows on the Indian manufacturing sector.

Inflation a worry

The inflow of billions of dollars of money into Indian stocks can also fuel inflation, which is now slowly coming under control after stubbornly refusing to yield to RBI’s measures to temper it over the past few months.

This will have an immediate impact on the yield curve of bonds and, in turn, on interest rates – and, consequently, on the value of the rupee.

The RBI will have to balance its act very delicately – so as not to kill the goose that lays golden eggs, while at the same time ensuring that the rupee doesn’t rise to levels that make the Indian economic recovery unsustainable.

Narrow band

Many analysts expect the RBI Governor Shaktikanta Das to ensure that the rupee trades in a narrow band of Rs 71.00-73.50 per dollar through most of this year. Market analysts and traders point out that the RBI had purchased $58 billion of dollars in the first nine months of the year. This kind of active intervention by the central bank is expected to continue over the coming quarters as well.

This will give confidence to foreign investors that investments made in India with an eye on the global export market will remain viable over the long run.

And this will play a crucial role in India’s economic recovery over the coming quarters.